Rebuilding Your Investment Portfolio
Kirk Shinkle

When it comes to investing, climbing out of a hole always takes a lot longer than falling in.

It has been well over a year since the worst crisis in decades rocked Wall Street, sending nearly every class of financial assets--from stocks to bonds to real estate--into a tailspin. Markets have managed to claw back from some of those substantial losses, but nearly everyone is still feeling poorer than just a few years ago. So where do average investors stand today when it comes to regaining all that lost investment, especially the millions of Americans nearing retirement age? In many cases, they're still digging out.

What we've lost.

No doubt about it: Most older Americans are struggling to recover from their investment losses. The question is how long it will take for portfolios to rebound. Jack VanDerhei, research director of the Employee Benefit Research Institute, took a look at battered 401(k) plans and estimated what it might take to return to precrisis account balances.

First, some facts about the damage done: VanDerhei says the median decline for 401(k) plans that posted losses between Jan. 1, 2008, and early August 2009 for investors ages 45 to 64 was 19.6 percent, or a median loss of $12,386. Losses in retirement plans were less horrific than the broader equity market because most 401(k) accounts have some allocations to bonds. But the pain was generally worse for older workers, who have larger retirement savings. For them, the dollar loss was bigger, even with more conservative allocations.

So, how long do older workers need to wait to see a full recovery in their 401(k)'s? That depends on two major factors: how much you can save and how quickly markets grow. The key will be savings.

Let's look at an example of how bigger contributions can help. If at the start of 2008, Susie Smith had $100,000 in retirement savings, as of August 6, the value of her retirement account would have fallen to $80,400. If she contributes 5 percent of her account value annually, or $4,020 per year, it will take her one year and nine months to return to 2008 levels, assuming an 8 percent return, VanDerhei estimates. If she contributes 10 percent--or $8,040--her account will recover in one year and four months, he says.

Let's take a look at the role of returns. Eight percent a year is an above-average gain for many portfolios, so what happens if long-term economic damage caused by the recession conspires to keep markets rising at a slower-than-normal pace--say, 4 percent a year? There, an employee with 20 years at a company contributing 10 percent of his or her account balance each year would still be able to recover in just over a year and a half. An 8 percent return cuts the recovery time to a year and a month.

Still, just getting back to 2008 levels is cold comfort for many retirees also facing an uncertain economy, especially if an unforeseen event like a spouse's job loss threatens savings habits. But it's important to resist tempting options like reducing retirement contributions. In fact, that may be the worst possible decision. A halt in new contributions to an existing 401(k) right now for workers with 20 years at their firm pushes the recovery time to two years and 10 months at an 8 percent return. If the market slows to a 4 percent return, getting back to 2008 levels could take a painful five years and nine months, VanDerhei says. That's a lot of time, especially for people who have only a handful of years left before retirement. Luckily, few investors have stopped contributing altogether, though many are putting in less after employers pulled back on matching employee contributions.

Reconsidering a safe retirement plan.

At the same time, Americans heading for retirement are looking hard for new ways to preserve what's left of their nest eggs in the future. The buy-and-hold mentality among many longtime investors, coupled with simple formulas for retirement based on assumed annual returns for a mix of stocks and bonds that changes like clockwork as you age, look less appealing during the current downturn. Normally, the rule of thumb is that you can take out 4 percent of your assets when you retire and then repeat that process, adjusting for inflation, every year for the rest of your life. It's an easy formula, and one that didn't work very well for retirees chastened by last year's market declines.

Some advisers are taking different approaches to retirement planning, recommending that clients put their assets in several different "buckets" that correspond to different stages of their expected retirement. There are various options for building buckets, but the underlying idea is this: Instead of planning on the same withdrawal percentage each year, people should place money in blocks designed to produce income for a set period, often five to seven years. That bucket will include mainly supersafe investments, like shorter-term treasuries, which will almost certainly provide the expected income. The other buckets, designed for similar chunks of time later in retirement, include slightly riskier assets, like a mix of stocks and bonds, which have the potential to grow more quickly than the first bucket but also have time to recover if markets take an unfavorable turn. Similarly, a third bucket would hold the riskiest assets with a heftier tilt toward stocks, real estate, or commodities. As retirees age, they shift the buckets to more conservative investments and replenish their safest fixed-income investments to cover several years' worth of spending. Then, if, for example, stocks take a hit, retirees can simply choose not to shift a year or two worth of assets into bonds. Planning retirement using such buckets provides more peace of mind, says Stephen Huxley, a principal at Asset Dedication who consults on such strategies. "It has the advantage of being psychologically comforting for individual investors," he says. "It calms the environment in which they live."

The big unknown: inflation.

Some calm would be welcome about now. Unfortunately, there are still lots of unanswered questions about the economy. The biggest might be inflation. Even during the best of times, economic forecasting is a murky business, but clarity dims even more when markets are pushed to extremes as they've been for much of the past year and a half. For example, it's not clear how or when consumer spending, home prices, credit availability, or a host of other market-influencing factors will snap back. Plus, massive government spending, bailouts, stimulus packages, and very low interest rates could easily conspire to boost long-term price pressures. For retirees, it's an issue of timing. If, over the next few years, inflation moves up only modestly, stocks and bonds will both most likely produce respectable returns. However, if inflation surges, bond returns could be hurt badly, and companies will face higher labor and production costs that can hurt share prices.

So, it might be wise to hedge against the possibility of soaring inflation. The best bet is to play it safe: If you think inflation is on the way, invest more heavily in commodities and Treasury inflation-protected securities, or TIPS, but keep some deflationproof holdings like regular treasuries or ultrasafe municipal bonds just in case you bet wrong. On the other hand, if you think we're still on track for more economic hardship and deflation is at hand, up those same safe bets, but keep a handful of TIPS or commodities just in case (note that either scenario isn't the kind of situation that's good for stocks). Economists say such decisions depend on your individual investments and needs, but a strategy that includes an eye toward unforeseen shifts in price pressures is worth considering. "What we have to admit now is that the odds of an extreme event are higher than we thought a couple of years ago. It would be prudent to keep that in the back of our minds as we do long-term planning," says Robert Dye, a senior economist at PNC Financial Services Group. He sees moderate inflation ahead once the recovery gets underway. "There is certainly potential for inflation to re-emerge."

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